DeFi offers users access to borrowing and lending opportunities. However, as the popularity of DeFi borrowing platforms grows, so do the associated risks. This article will explore the best practices for DeFi borrowing.
What is DeFi Borrowing?
DeFi borrowing, or decentralized finance borrowing, is like getting a loan in the digital world.
Instead of dealing with traditional banks, you borrow and lend directly with other users through smart contracts on blockchain platforms.
It allows you to borrow cryptocurrencies using your crypto as collateral without a central authority.
What you need in order to borrow in DeFi
If you want to borrow on a DeFi platform, you will need the following:
- Digital wallet
- Cryptocurrency
- DeFi Lending Platform
Digital wallet
A digital wallet, also know as a crypto wallets or a web3 wallets, is a wallet that holds cryptocurrencies and other digital assets.
The best wallets are self-custodial like the trust wallet. Self-custody means you have full control over the contents of the wallet.
On the other hand, a third party has ultimate control in a custodial wallet.
Cryptocurrency
The crypto wallet will need to contain cryptocurrency to pay for transaction fees as well as to swap.
Transaction fees are used to pay for actions that change a blockchain. They will be paid in the blockchain’s native currency.
For example, ETH is used to pay for transaction fees on the Ethereum blockchain. In order to borrow on a decentralized lending platform, you will first need to post collateral against which to borrow.
Lending platform site
It’s important to use a reputable lending platform that accepts many quality cryptoassets, and has competitive yields.
How Do You Borrow Money in DeFi?
To start borrowing on a DeFi platform, go to a reputable lending protocol such as Aave.
Connect your web3 wallet to the DApp. Before you can borrow, you must deposit some crypto assets that you can use as collateral.
Once you’ve deposited collateral, go to the “borrow” section of the DApp. Lending platforms will have a list of crypto assets you can borrow.
Each cryptoasset will have a different interest rate you will have to pay. Choose a cryptoasset you wish to borrow, and specify how much you want to borrow.
The maximum amount the DApp will let you borrow is based on how much collateral you have available.
It’s prudent to borrow less than the maximum amount, since that will protect you against liquidation if your collateral decreases in value.
Best Practices for DeFi Borrowing
With the rise of DeFi comes the need for best practices to ensure the security and safety of users and their assets.
The following are the best practices for DeFi borrowing:
- Conduct Extensive Research
- Diversify Your Portfolio
- Understand Collateralization Ratios
- Stay Informed About Market Conditions
- Use Reputable Crypto Wallets
- Implement Two-Factor Authentication (2FA)
- Start Small and Test the Platform
- Do Regularly Research
- Monitor Gas Fees
- Have an Exit Strategy
Conduct Extensive Research
Before engaging with any DeFi borrowing platform, conduct thorough research on the project’s background, team, and security measures.
Verify the platform’s smart contract security through audits from reputable firms and check for any historical security incidents.
Diversify Your Portfolio
Spread your assets across multiple borrowing platforms to mitigate the risk associated with platform-specific issues.
Diversification helps protect your investments from potential vulnerabilities or exploits on a single platform.
Understand Collateralization Ratios
Pay close attention to collateralization ratios required by borrowing platforms.
Maintaining an adequate collateralization ratio ensures that your assets are sufficiently backed, reducing the risk of liquidation in case of market volatility.
Stay Informed About Market Conditions
Monitor market conditions and be aware of potential price fluctuations in your collateral assets. Sudden market movements can impact your collateralization ratio and increase liquidation risk.
Use Reputable Crypto Wallets
Secure your assets by using reputable and well-established crypto wallets.
Hardware wallets or well-known software wallets with a track record of security are recommended to safeguard your private keys and prevent unauthorized access.
Implement Two-Factor Authentication (2FA)
Enable two-factor authentication whenever possible to add an extra layer of security to your accounts.
This additional step helps protect your assets from unauthorized access in case of a compromised login credential.
Remember, it’s better to be safe than sorry.
Start Small and Test the Platform
Begin by testing DeFi borrowing platforms with a small amount of funds before committing a significant portion of your assets.
This allows you to familiarize yourself with the platform’s mechanics and identify any potential issues without risking substantial losses.
Do Regularly Research
Stay informed about the latest developments in the DeFi space, including protocol upgrades, changes in governance, and security improvements.
Regularly updating your knowledge ensures that you adapt to the evolving landscape and make informed decisions.
Monitor Gas Fees
Keep an eye on gas fees associated with transactions on the Ethereum network. High gas fees can significantly impact the cost-effectiveness of utilizing DeFi platforms, so consider the fee structure in relation to the size of your transactions.
Have an Exit Strategy
Establish a clear exit strategy and be prepared to react swiftly to changing market conditions.
Having predefined stop-loss levels and profit-taking targets helps you manage risks and ensures a disciplined approach to DeFi borrowing.
Conclusion
Safely navigating DeFi borrowing platforms requires a combination of due diligence, risk management, and continuous learning.
By implementing these best practices, users can enhance their security, reduce exposure to potential risks, and participate more confidently in the decentralized financial ecosystem.
As the DeFi space continues to evolve, staying informed and adapting to new challenges will remain essential for a successful and secure borrowing experience.
